Example 16B: GDP was $6,174 billion in 1991 and was $6,539 billion in 1992. What was Real GDP in 1992, adjusted to the 1991 price level? The GDP deflator was 69.0 in 1991 and was 70.6 in 1992. Real GDP (1992) = $6,539B ÷ (70.6 ÷ 69.0) = $6,539B ÷ 1.0232 = $6,391B In this case, the increase in nominal GDP was caused by both an increase in Real GDP and an increase in the price level. Example 16C: GDP was $14,478 billion in 2007 and was 14,719 billion in 2008. What was Real GDP in 2008, adjusted to the 2007 price level? The GDP deflator was 97.3 in 2007 and was 99.3 in 2008. Real GDP (2008) = $14,719B ÷ (99.3 ÷ 97.3) = $14,719B ÷ 1.0206 = $14,422B In this case, even though nominal GDP increased from 2007 to 2008, Real GDP did not. Real GDP decreased from 2007 to 2008. The increase in nominal GDP was due solely to the increase in the price level (inflation). As illustrated in the examples above, an increase in nominal GDP from year to year does not necessarily mean that production has increased. To determine if production has increased, we compute Real GDP. Absolute economic growth refers to an increase in Real GDP. (In Chapter 14, we distinguish between absolute economic growth and per capita economic growth.) The Business Cycle Real GDP tends to behave in a cyclical manner, called the business cycle. The upturns and downturns in the business cycle are unpredictable in terms of when they will occur, how long they will last, and how severe they will be. The four phases of the business cycle are called: 1. Expansion – when Real GDP is increasing. 2. Peak – the highest phase of the business cycle. 3. Contraction – when Real GDP is decreasing. 4. Trough – the lowest phase of the business cycle. Appendix: Flaws in GDP as a Measure of Standard of Living Gross domestic product (GDP) measures the market value of all final goods and services produced annually. As such, GDP, particularly when stated on a per capita basis, is considered a measure of a nation’s standard of living. As a measure of standard of living, GDP contains a number of flaws, including: 1. GDP does not include nonmarket production. Nonmarket production (e.g. do-it-yourself) can be very valuable and has a strong impact on a nation’s standard of living. But nonmarket production is not included in GDP. GDP comparisons between a nation that has a relatively large amount of nonmarket production and a nation that has a relatively small amount of nonmarket production will be misleading. Nonmarket production is typically a larger share of total output in less developed countries than in developed countries. Comparisons of GDP between developed countries and less developed countries will thus tend to overstate the difference in standard of living. 2. GDP does not include underground (unreported) production. Production that is unreported for tax evasion purposes is nonetheless valuable production that increases a nation’s standard of living. And production that is unreported because it is illegal also has a market value and arguably increases a nation’s standard of living. Underground production is typically a larger share of total output in less developed countries than in developed countries. Comparisons of GDP between developed countries and less developed countries will thus tend to overstate the difference in standard of living. FOR REVIEW ONLY - NOT FOR DISTRIBUTION Measuring Total Output: GDP 5 - 6

Example 17: In “An International Comparison of Underground Economic Activity”, Friedrich Schneider and Christopher Bajada estimated that the underground economy for the generally developed countries of the Organisation for Economic Co-operation and Development averaged 16.3% of GDP in 2002/2003. For the generally less developed countries of Central America and South America, the underground economy averaged 43.4% of GDP. For the generally less developed countries of Africa, the underground economy averaged 43.2% of GDP. 3. GDP does not include differences in leisure time. Leisure time affects a nation’s standard of living, but is not included in GDP. Leisure time is typically greater in less developed countries than in developed countries. Comparisons of GDP between developed countries and less developed countries will thus tend to overstate the difference in standard of living. 4. GDP does not adjust for economic bads. An economic bad could actually increase GDP. The damage done by an industrial accident or a flood would not be deducted from GDP, but the market value of the production necessary to repair and replace damaged property would add to GDP. Economic bads detract from a nation’s standard of living. Appendix: The Three Macroeconomic Goals and the U.S. Economy The three macroeconomic goals are price level stability, full employment, and economic growth. A nation’s success in achieving these goals is measured by its inflation rate, unemployment rate, and Real GDP growth rate. The table below indicates these three rates for the U.S. economy for selected years. Year Inflation Rate Unemployment Rate Real GDP Growth Rate 1929 0% 3.2% 6.5% 1930 -2.3 8.7 -8.6 1931 -9.0 15.9 -6.4 1932 -9.9 23.6 -13.0 1933 -5.1 24.9 -1.4 1943 6.1 1.9 16.5 1944 1.7 1.2 8.1 1945 2.3 1.9 -1.1 1946 8.3 3.9 -11.0 1947 14.4 3.9 -0.9 1966 1.6 4.5 6.6 1967 2.9 3.8 2.5 1973 6.2 4.9 5.8 1974 11.0 5.6 -0.6 1975 9.1 8.5 -0.4 1980 13.5 7.1 -0.2 1981 10.3 7.6 2.5 1982 6.2 9.7 -2.0 1983 3.2 9.6 4.3 1984 4.3 7.5 7.3 1990 5.6 5.4 1.9 1991 6.8 4.2 -0.1 1992 7.5 3.0 3.6 2007 2.8 4.6 1.8 2008 3.9 5.8 -0.3 2009 -.4 9.3 -2.8 2010 1.6 9.6 2.5 2011 3.1 8.9 1.6 2012 2.1 8.1 2.3 2013 1.5 7.4 2.2 FOR REVIEW ONLY - NOT FOR DISTRIBUTION 5 - 7 Measuring Total Output: GDP